Mid-Year Report: Despite DVD Drop, Optimism

Two years ago, when DVD's long period of double-digit growth came to an abrupt end, studio executives were beside themselves with worry. For nearly a decade, they might as well have been minting money, but as 2005 wound down the big hits, in particular, weren't selling as well as expected. And when the final year-end numbers came out, they showed business flat with the previous year.

So far this year, the home video business is down, not flat. Sales estimates vary, but Home Media Magazine estimates consumer spending on video purchases slipped about 3% in the first half of this year, coming in at $6.8 billion, down from $7 billion in the first six months of 2006.

And with VHS virtually eliminated from even the most rural Wal-Mart and most studios no longer even manufacturing cassettes, the old culprit — a drag from the VHS phaseout — can no longer be fingered.

It's all about DVD, and DVD sales are down.

And yet there's no talk of doom and gloom. Instead, studio executives place the blame squarely on the weak slate of theatrical features that came to DVD in the first half of this year — and point with optimism toward the fourth quarter, when the summer blockbusters will arrive on DVD and hopefully put consumer spending back on track.

“The box office is up 5% so far this year, and as a product-driven business this theatrical uptick bodes well for the DVD business later in the year,” said Mike Dunn, president of 20th Century Fox Home Entertainment.

“Almost all of the decline [in consumer spending in first-half 2007] can be attributed to theatrical releases to date, and there is no doubt this will turn around in the fourth quarter,” added Steve Beeks, president and COO of Lionsgate.

None of the big summer movies have been announced as of yet for DVD release, but industry observers expect the three heavyweights — installments No. 3 of “Spider-Man,” “Shrek” and “Pirates of the Caribbean” — to drop in October, November and December, respectively, driving consumers into stores and lifting sales of other titles, as well, given that 40% of DVD sales are believed to be impulse purchases.

“As we've seen, strong box office is one of the key factors in predicting strong home entertainment sales, and the 2007 box office is running ahead of last year,” said Kelley Avery, president of worldwide home entertainment for Paramount Pictures.

“By the end of the year the positive effect of the fourth-quarter releases will lift the current trend to end the year flat or with a slight decline in year-year-over year performance,” noted David Bishop, president of Sony Pictures Home Entertainment.

In hard numbers, Sony projects total 2007 consumer spending on home video to come in at $23.4 billion, down 2% from 2006. Spending on DVD sales is expected to reach $15.7 billion, while rentals should come in at $7.7 billion.

Last year, spending came in at $24.2 billion, with $16.6 billion in DVD sales and $7.5 billion in DVD rentals.

Two years ago, such words as “flat” or “slight decline” would have been cause for alarm, but not this time.

“Two years ago, we didn't expect to see the dip we saw, but this year we all recognize that the business is mature,” said Ron Sanders, president of Warner Home Video. “The U.S. box office for titles that have been released to home video so far this year is down about the same percentage as the new release business, 8% or 9%. In a mature business, spending is product-driven.”

The total box office value of titles expected to be released in the second half of this year, according to Warner research, is $5.2 billion, up from $4.9 billion in the second half of 2006.

Managing that “huge box office” will be a challenge, studio presidents say. The shelf-space crunch at retail is only getting worse. Retailers aren't expanding home video footprints because of flat sales, while the influx of two next-generation formats, Blu-ray Disc and HD DVD, is crowding existing space even more.

“With the competing HD formats and the use of both widescreen and full-screen versions on standard-definition product, shelf space has become increasingly challenged,” Bishop said. He sees relief only when one of the rival HD formats goes away, and when the proliferation of widescreen TVs makes full-screen DVDs a thing of the past.

“At the end of the day, shelf space is a function of the profitability our products deliver to our distribution channels,” notes Stephen Einhorn, president and COO of New Line Home Entertainment.

Managing shelf space is just one of the challenges of doing business in a mature market, studio presidents say. Distribution must expand, which is why so many studios and independent suppliers alike are targeting new retail channels, from airport gift shops to sporting good stores. Studios must develop new programs and initiatives, such as the direct-to-video divisions that have sprung up at several major studios in recent years. And, at the same time, expenses must be cut.

“Every home entertainment distributor has to work harder and smarter to succeed,” Paramount's Avery said. “In addition to our new theatrical and direct-to-video titles, we've got to be more strategic in our marketing and drafting opportunities for catalog titles.”

“You really have to focus on the pennies and taking the costs out of the system,” Warner's Sanders added. “We have to be much more critical of supply-chain costs and how we spend our marketing dollars to make sure we are getting a bump.”

That said, Sanders doesn't discount the need for good old ingenuity. He notes pricey “complete series” boxed sets have lifted the overall TV DVD catalog business 13% year-over-year.

“Last year, we had phenomenal success with ‘West Wing' and ‘Friends.' So this year, we are doing more, including a complete series box of ‘The O.C.' and ‘Full House,’ Sanders said. “It's become a real nice business for us in the fourth quarter, and because of the price points it doesn't require huge unit volume to do strong numbers.”

20th Century Fox's Mike Dunn takes a philosophical approach.

“The market doesn't need to grow for us to grow,” he said. “We've structured our business to identify and exploit growth opportunities wherever they exist. One way is building scale through strategic partnerships like MGM and HIT. Another, more organic type of growth comes from identifying underserved consumer segments like our Fox Faith business and categories in which we have the opportunity to broaden our portfolio, as we've done through internal development, production and key acquisitions. And we're also looking overseas for growth in places like Russia, where we're in business now, and China, where we recently announced a joint venture.”

Studio presidents also are anticipating sharp growth in the sale of packaged high-definition media, despite the format war between rivals Blu-ray Disc and HD DVD.

“I think the question to ask is what high-definition packaged media can offer consumers that they can't get today, and there are two key answers,” said Craig Kornblau, president of Universal Studios Home Entertainment. “The first is incredible quality, and the second is interactivity, which extends the experience beyond the movie and takes the viewer inside the film and even inside the community.”

Note that Bishop said “Blu-ray,” not high-definition. Sony is one of four hard-line studios supporting only Blu-ray. The others are Buena Vista Home Entertainment, 20th Century Fox and Lionsgate, while Warner and Paramount support both. Only Universal Studios Home Entertainment exclusively supports HD DVD, the decided underdog. Software sales are running about 60% in favor of Blu-ray.

Sanders echoes growing sentiments that the format war between Blu-ray Disc and HD DVD isn't hampering acceptance of next-generation packaged media. Indeed, it may actually be helping it, he said, by putting pressure on hardware manufacturers to drop prices — and on both camps to step up promotional efforts.

“To me the corollary is how we had Divx in the early days of DVD, which forced both camps to get very aggressive in hardware pricing and marketing, and which in turn allowed DVD to take off much more quickly than it would have had we not had Divx in the market,” Sanders said.

Bishop and Dunn adamantly disagree. “The cost of consumer confusion and slower adoption outweighs the argument for the accelerating drop in hardware pricing,” Bishop said. “Further, retailers are negatively affected by the format war by having to provide space for under-yielding formats, thus subverting format expansion and their own economic performance.”

Also a factor these days in every studio president's mind is digital distribution. But is it really a business yet?

“Consumers have spent about $35 million in electronic sellthrough, on movies only, since iTunes started offering downloads [in late 2005],” Lionsgate's Beeks said. “That spend could total about $100 million this year, if current trends continue.”

By 2010, Beeks said, he would envision consumers spending upwards of $1 billion on movie downloads, but that still pales in comparison to where packaged media stands today — and where it will likely continue to be at in the foreseeable future.

“Every time you make entertainment content available in new ways, with new technology, the pie grows,” Warner's Sanders said. “The consumer tends to not only do the legacy way of consuming media, but then there is a group of the population that also wants to try the new way-so it tends to be additive.

“And there's no reason to doubt it won't be the same scenario with digital and physical media.”